What Eskom will gain with a 60% price hike

Tim Cohen, Dealweb, Johannesburg, 9 April 2008

It could result in the company earning an extraordinary R12,7bn in profit -more than all but the handful of the largest companies on the JSE.

Eskom's shock application to the National Energy Regulator of South Africa (Nersa) to approve a 60% tariff increase would result in the company earning an extraordinary R12,7bn in profit - more than all but the handful of the largest companies on the JSE.

This has raised questions about whether Eskom management are appropriately incentivised, since a management bonuses are largely based on the utility's profitability.

Documents released yesterday also reveal that the eye-poping 60% increase application would only be the first of several, and the application not only requests an increase this year but a 43% real increase for the year 2009/10. The documents include the controversial "censored" Eskom draft application and Nersa's response.

Nersa has questioned why Eskom should want an increase which would, on it's calculations, result in such a large profit - almost four times the profit it earned last year - only three months after it applied for a much smaller increase of 18%.

Nersa previously granted Eskom a 14,2% increase, which Eskom now says would result in a loss after tax in the range of from R1bn-R10bn, "which would place additional pressures on funding".

The utility put forward five different scenarios, but argued for the highest increase on the basis that "tariffs should be reflective of prudent costs" and that it is essential that prices be adjusted to reflect the cost of supply.

"Should this not be the case, then the under-recovery will need to be borne by the taxpayer, thereby further distorting the price levels," the Eskom ‘s submission to Nersa states.

Nersa costed all five scenarios, and included the likely profits of each one what would accrue to Eskom. This was done on various different scenarios, but the one Eskom has applied for would include the assumption of 53% increase in what it describes as "primary energy" - mainly coal in Eskom's case - and additional costs of R2,5bn for something called "accelerated demand side management".

Even after these are included, Nersa calculates that Eskom would make a profit of R12,7bn, which matches, for example, the profit of R12, 7bn declared recently by Standard Bank, the ninth largest stock on the JSE, after its best financial year.

The application for the increase is so surprising to Nersa partly because it includes the government loan of R60bn announced in the budget, of which R6bn will be drawn down in 2008/08. It also includes the assumption of a maximum borrowing by Eskom of R30bn annually over the next five years and reduction in electricity demand due to Power Conservation Program.

Nersa member for electricity Thembani Bukula told Engineering News that the regulator was in the process of establishing an advisory committee and appointing local and international consultants to help it in determining whether or not Eskom's request was reasonable.

However, he said that, from a personal perspective, he remained somewhat "shocked" by the request. "It is also shocking, because three months ago [when the14,2% increase was granted for the 2008/9 financial period], I did not have the view that three months later we would have a 60% increase, as I have not seen prices of coal and other inputs to Eskom's primary energy increasing at that rate," Engineering News quotes Bukula as saying.

Eskom's counter argument is that the tariff rise and the resultant earnings were necessary to protect its credit rating and to provide funders with the comfort they needed support its R450bn capital expansion programme.

"Due to the steep change in primary energy and the capital expansion programme from R150bn to R301bn (R343bn nominal), the financial health of Eskom has come under tremendous pressures which resulted in Standard and Poor's (credit rating agency) placing Eskom on "credit watch". The funding of the build programme in the short term would require a combination of Government support and significant price increases," it said.

Yet criticisms of the basis on which Eskom is estimating its costs comes from other quarters too.

Sanlam economist Jac Laubscher said in a note to clients that there are so many types of coal, each with its own price, that it is difficult to make a general statement regarding price movements in the spot market.

However, the export price of coal ex Richards Bay has increased by approximately 30% since November 2007, "which indicates that Eskom's requested tariff increase of 53% is excessive". A large part of Eskom's coal requirements is also met by means of long-term contracts and not by the spot market, although the latter is increasing, he writes.

"This conveys the impression that it's not just about higher coal prices, but that Eskom wants to pass on to consumers the cost of restoring its coal stocks to acceptable levels. In other words, Eskom wants to finance the implied increase in its operating capital by means of higher tariffs, which is not a sound financial principle."

"One could argue that consumers benefited from the reduction in power stations' coal stocks in the past as it made lower tariffs possible. It would therefore only be fair if consumers were to pay for the restoration of stock levels now."

"But Eskom's management also benefited financially from the reduction in coal stocks as it meant better short-term financial results - the basis on which bonuses were calculated. The lower coal stocks logically also contributed to the dividends the government received from Eskom," he writes.

Government has also in principle expressed its support for Eskom's request. According to minister Alec Erwin, Eskom cannot be expected to absorb the rise in the cost of coal and diesel.